The reasons why voters in France and the Netherlands rejected the European Constitution a few weeks ago were many. But two overarching themes of the referendums were discontent and fear: discontent with politicians and their inability to revitalize the lagging economies of many EU countries, and fear of what the future may hold for people accustomed to secure jobs and generous social-welfare benefits.

Indeed, the question of whether EU nations can continue to maintain their social safety nets and employment perks — generous health care and pension benefits, job security, long vacations and short workweeks — in the face of prolonged economic sluggishness is not a new one. But the ‘No’ votes by the Dutch and the French, coupled with an aging population, growing competition from low-wage nations like China and the former communist countries of Eastern Europe, have focused new attention on the issue. In addition, a top U.S. official on June 14 chided European leaders who use anti-capitalist rhetoric. Treasury Secretary John Snow, visiting Brussels, urged European governments to continue free-market reforms and to shun language and policies that deter investors, the Financial Times reported.

Scholars at Wharton and at universities in Europe say that the 25-member EU — especially the core members of the so-called Old Europe: France, Germany and Italy — must institute free-market, Anglo-Saxon-style reforms to ignite a spark under the economies. In particular, they point to labor laws that make it difficult and expensive to hire and fire people. But some also say that Europe can achieve higher growth rates, as measured by gross domestic product, without completely abandoning the social welfare policies that have been at the heart of Europe’s identity since World War II.

“This has been an issue for years and years but one that neither France nor Germany has been willing to raise in a serious way,” says Richard Marston, finance professor and director of the Weiss Center for International Financial Research at Wharton. European governments, he adds, “must be willing to undertake fairly radical reforms.”

“The old lethargic giants of Europe — France, Germany and Italy — badly need reform to get their labor markets more flexible and have their pension systems sustainable,” says Rick van der Ploeg, professor of economics at the European University Institute in Florence, Italy, and a former member of the cabinet of Wim Kok, a one-time Dutch prime minister. “They protect their own industries too much and have a defensive rather than offensive agenda. They hold Europe back.”

“Many people agree that continental Europe has to adopt more market-friendly policies,” says Bruce Kogut, a former management professor at Wharton who now teaches at INSEAD in France. “But Americans often mistakenly believe that countries that supply high social benefits don’t grow or are not rich. This is simply false. There are many countries, such as Denmark or the Netherlands, that maintain high levels of social services and have relatively low unemployment.”

To be sure, Europe’s economic performance has left much to be desired in recent years. Among the 12 countries that use the euro as their common currency, GDP growth is projected to drop from just below 2% in 2004 to 1.25% in 2005, before rebounding to about 2% in 2006, according to the Organization for Economic Cooperation and Development. In the United States, by contrast, GDP growth was 4% in 2004, and is projected to be 3.6% in 2005 and 3.3% in 2006, OECD figures show.

‘Creative Destruction’

Frederique Sachwald, an economist at the French Institute of International Relations, says that too much emphasis is sometimes placed on labor-market reforms as a way to revitalize Europe’s economies. More competition in goods and services, particularly in France and Italy, would “contribute to the process of ‘creative destruction,'” she says, using the term made famous by the economist Joseph Schumpeter.

Sachwald stresses that the level of reform required will vary from country to country. “EU members are a quite diverse crowd on this issue,” she says. “Some countries are growing rather strongly, like Ireland and the U.K. Spain has growth, but is still in a catching-up phase and also has low productivity because it generates jobs with construction rather than industry. The Scandinavian countries have made drastic reforms since the 1990s and are also research-and-development intensive, but do not necessarily enjoy strong growth. The new members [the 10 former Eastern European countries that joined the EU in 2004 and are known as New Europe] are emerging countries with relatively strong growth and a quest for liberalization. Now the three continental countries are experiencing a slow growth and high unemployment: France, Germany and Italy. They are going at different speeds in adopting a number of reforms.”

Wharton finance professor Franklin Allen says high tax rates in Germany and France are also problematic in that they discourage people from wanting to work there. “The countries that seem to do well are the ones that have tax reforms that change the way people work. I’ve talked to French MBA students about this. If you ask whether they are going to go back home [after graduation], most say ‘No, we’re going to go to London.’ It’s difficult for people to move ahead economically because of the way tax systems are constructed. When I grew up in the U.K., we lagged 30% or 40% behind Germany and France in per capita GDP. Things have changed.”

Many experts, however, see labor-market reforms as being most pivotal to economic growth.

Finance professor Richard J. Herring, director of Wharton’s Joseph H. Lauder Institute of Management and International Studies, says Europe’s economic problems stem from the level and kind of benefits many in “Old Europe” receive and how those benefits are financed. For one thing, benefits shield the unemployed from a considerable amount of the loss of income and are generally not tied to retraining that would make them employable. Thus, countries can build up large numbers of unemployed who lack strong motivation and the skills to find new work. In addition, these benefits are generally financed as a tax on employment. This means that the social overhead costs of hiring a worker are very high and corporations are correspondingly reluctant to hire when demand rises. 

Many people in Old Europe still prefer this system, but it is increasingly difficult to sustain. “Globalization, and in the case of the EU, eastward expansion to New Europe, is viewed as a threat to this system because countries with a more Spartan social safety net are often able to produce goods and services at lower cost,” Herring explains. “The euro complicates this because it means that the exchange rate cannot be used to ease adjustment for individual countries. It leads to an interest rate that is too low for some countries, such as Spain and Ireland, and too high for others, such as Germany. Of course, the threat is not just New Europe, but most of Asia. Old Europe would like to pick and choose the parts of globalization they accept, but it really can’t be ordered a la carte.”

Wharton’s Marston points out that one reason unemployment rates in Germany and France are so high — a little over 10% in both countries — is that their labor markets are rigid.

“In the U.S. we have the notion that if the unemployment rate rises to 5% from 4.5%, things are bad,” Marston says. “But in Europe unemployment rates can be 10% or 12%, which means there has to be something radically wrong. There are built-in restrictions on hiring of labor and, more importantly, on the firing of labor…. In Germany you have to go to a work council to arrange how to fire a worker. Also, the welfare system for an unemployed worker is much more generous than in the U.S. There’s less pressure to find a new job. The microeconomics in Europe work against full employment.”

Mauro F. Guillen, professor of international management at Wharton, says another chief issue facing labor markets in European economies is the national regulations in some service industries that continue to prevent the formation of a single, free market. “There is a kind of rigidity in Europe that is absent in the U.S. and that will be difficult to overcome. There are language, cultural and legal barriers — for instance, different tax systems — that make it hard for people to move around the EU. Thus, Europe as a whole will have a rigid labor market for quite some time.”

Wharton finance professor Nicholas Souleles agrees that labor-market reforms are crucial for long-term growth, but points out that they will not be readily accepted because the immediate costs might be hard to endure. “The problem is there’s a short-term cost implicit in these kinds of changes in economies that are already pretty weak.” Suppose, for example, that a new, reform-minded law reduces restrictions on the circumstances under which a company can cut its workforce. This flexibility may help in the long term, but it might raise unemployment rates in the near term. “You might have a short-term surge in firing, and if that’s done at times of high unemployment, it can be hard to implement,” he says.

Still, Souleles goes on to note that it is important for political leaders and labor unions to bite the bullet and focus on the long term because current restrictions on hiring and firing intended to keep unemployment low may not be achieving what they are designed to accomplish. “Labor is by far the biggest component of firms’ costs. And if you look at the biggest macroeconomic indicators of those countries, the one that jumps out at you is high unemployment.”

Old Attitudes about Wealth Creation

Van der Ploeg of the European University Institute sees another major impediment to economic growth — namely, “a higher education system with too little differentiation and which does not prepare the brightest youngsters to take risk, look ahead and innovate.” To turn their economies around, van der Ploeg also believes Germany, France and other social welfare states should “raise the nominal and effective retirement age, get more people to work longer hours, and encourage risk taking and enterprise.”

Kogut agrees that “a better university system would help. In many countries, education is too long, the quality of the facilities is bad, and the divorce between universities and business is too big.” Additionally, Kogut sees three factors inhibiting economic improvement: “One is that there still are too high bureaucratic hoops to jump through in many, but by no means all, countries. Then, in some countries, business taxes and fees are too high. In countries like Sweden, contrary to popular images, the business environment is fairly positive in this sense. Third, there is a certain mentality in Europe, and this is probably the toughest [obstacle to overcome]. People in Europe don’t really understand venture capital and new firms; they are sometimes suspicious of wealth-creation and of the political power that goes along with it. We should keep in mind that big business in Europe has a mixed history.”

Vanessa Strauss-Kahn, an INSEAD economics professor, says many of the French citizens who voted ‘No’ to the EU constitution did so to register their dislike for poor economic performance. But Strauss-Kahn and others say there were other reasons at work too, ranging from a fear of competition for jobs from lower-wage workers in Eastern Europe to being confronted with a long, complex text that probably few people, even the educated, understood. Plus, she says, “there is a small proportion, maybe 10% to 15%, of all voters who are against Europe and will be forever.”

Does the ‘No’ vote in France make it harder for Paris to institute free-market reforms? “On the one hand you can see people are not happy with life, so it should be easy to go for reform,” she says. “But some reforms have to do with labor markets and that will not be well accepted. It’s going to be a very tough job for the next government.”

All Is Not Lost

The European political elite and various commentators, understandably so, became apoplectic after the ‘No’ votes in France and the Netherlands. Some wondered whether the votes marked the beginning of the end of European integration. There is no question that the rejection of the constitution was a blow to elected officials — especially French President Jacques Chirac, who championed the constitution — and that it does raise serious and complex uncertainties about the future of the EU. But some of those interviewed by Knowledge at Wharton feel that the votes — in reflecting the concerns of ordinary citizens, who are so infrequently polled by EU leaders about key issues — could also be helpful in reorienting the thinking of politicians, business executives, labor leaders and workers to look for ways to adopt reforms while at the same time maintaining a large proportion of Europe’s social safety net. Indeed, some countries and companies are already moving in that direction.

“In addition to Ireland and the U.K., which are really extremes in the European context, we find many countries trying out important reforms: Finland, Sweden, Denmark, Netherlands,” according to Kogut. “Not surprisingly, France is beginning to discuss the Scandinavian model again, but this time, as a model for market reforms with social policies.”

Kogut adds that the “stalling of the Constitution is a good thing in many respects. It slows down the rate of expansion, which many people do not like. It says enough immigration until we learn how to integrate. It perhaps will result in more democracy in European representation. Of course, many interpret this as a victory for the left, when in reality, it was a victory for the far right, which is a big factor in France and elsewhere.”

Marston notes that there have been some positive steps in Germany and France to loosen labor-market rigidities. For instance, when Siemens was trying to decide whether to open a new plant in a location in the former Eastern Europe, it asked the union representing its workers to renegotiate a labor contract. The union agreed, saying it was better to negotiate than to lose jobs. But sweeping reforms of the type many economists feel are needed to accelerate Europe’s economies remain a long way off. Says Marston: “On the private-sector level, the competition from Eastern Europe means the unions are beginning to have to give way in specific situations. But in terms of Europe as a whole, the unions will fight any attempts to do anything serious. This is going to be a major, major battle.”

Remember Maggie Thatcher

Marston says Europe should look to Britain as an example of a country that radically changed its economy through free-market reforms — starting with the election in 1979 of Margaret Thatcher as prime minister.

Van der Ploeg echoes that view. “Not only is the constitution dead, but Chirac and [German Chancellor Gerhard] Schroder are almost politically dead.” Perhaps, van der Ploeg adds, British Prime Minister Tony Blair “can move Europe forward.” Asked if the rejection of the constitution by France and the Netherlands will make it easier or harder for those countries and others to institute reforms, van der Ploeg responds: “Oddly enough, it may make it easier if the old leaders of the old Europe suffer humiliating defeats and are replaced by more reform-minded leaders.”

Wharton’s Allen believes the Anglo-Saxon economic philosophy admired by the newest members of the EU will be another factor working to push for free-market reforms. “I think the Eastern European countries favor a British view of the world. They don’t want huge integration; they want the economic benefits [of belonging to the EU] without the political intrusion.”

For her part, Strauss-Kahn of INSEAD thinks the EU can move toward Anglo-Saxon-style reforms while maintaining its traditional social-welfare umbrella. She cites Sweden as a country for France, Germany and others to emulate, noting that Sweden has retained a “huge safety net” for its citizens while at the same time spurring economic growth by undertaking major free-market reforms over the past five or six years.

“I’d like to see something in between [the Anglo-Saxon and European economic models],” Strauss-Kahn explains. “I do believe in redistribution schemes, as in France or Germany. I do like the 35-hour work week. On other hand, it is clear there are some big constraints to markets in many countries and a lot of experience has shown we could have the market work a little better.”